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Journal ArticleDOI

Mean reversion in corporate leverage: evidence from India

09 Sep 2019-Managerial Finance (Emerald Publishing Limited)-Vol. 45, Iss: 9, pp 1183-1198
TL;DR: In this paper, the authors make use of a major "shock" to the debt ratios as an event and think of a subsequent reversion as a movement toward a mean or target debt ratio.
Abstract: Recent papers on target capital structure show that debt ratio seems to vary widely in space and time, implying that the functional specifications of target debt ratios are of little empirical use. Further, target behavior cannot be adjudged correctly using debt ratios, as they could revert due to mechanical reasons. The purpose of this paper is to develop an alternative testing strategy to test the target capital structure.,The authors make use of a major “shock” to the debt ratios as an event and think of a subsequent reversion as a movement toward a mean or target debt ratio. By doing this, the authors no longer need to identify target debt ratios as a function of firm-specific variables or any other rigid functional form.,Similar to the broad empirical evidence in developed economies, there is no perceptible and systematic mean reversion by Indian firms. However, unlike developed countries, proportionate usage of debt to finance firms’ marginal financing deficits is extensive; equity is used rather sparingly.,The trade-off theory could be convincingly refuted at least for the emerging market of India. The paper here stimulated further research on finding reasons for specific financing behavior of emerging market firms.,The results show that the firms’ financing choices are not only depending on their own firm’s specific variables but also on the financial markets in which they operate.,This study attempts to assess mean reversion in debt ratios in a unique but reassuring manner. The results are confirmed by extensive calibration of the testing strategy using simulated data sets.
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229 citations

References
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Journal ArticleDOI
TL;DR: In this paper, a model of dynamic capital structure is proposed, where the optimal strategy is implemented over an arbitrarily large number of restructuring periods, a scaling feature inherent in the framework permits simple closed-form expressions to be obtained for equity and debt prices.
Abstract: A model of dynamic capital structure is proposed. Even though the optimal strategy is implemented over an arbitrarily large number of restructuring‐periods, a scaling feature inherent in the framework permits simple closed‐form expressions to be obtained for equity and debt prices. When a firm has the option to increase future debt levels, tax advantages to debt increase significantly, and both the optimal leverage ratio range and predicted credit spreads are more in line with what is observed in practice.

718 citations

Journal ArticleDOI
TL;DR: In this paper, the authors use a calibrated dynamic trade-off model to simulate firms' capital structure paths and find that in the presence of frictions, firms adjust their capital structure infrequently.
Abstract: In the presence of frictions, firms adjust their capital structure infrequently. As a consequence, in a dynamic economy the leverage of most firms is likely to differ from the “optimum” leverage at the time of readjustment. This paper explores the empirical implications of this observation. I use a calibrated dynamic trade-off model to simulate firms' capital structure paths. The results of standard cross-sectional tests on these data are consistent with those reported in the empirical literature. In particular, the standard interpretation of some test results leads to the rejection of the underlying model. Taken together, the results suggest a rethinking of the way capital structure tests are conducted.

647 citations

Journal ArticleDOI
TL;DR: In this article, the authors examine the evolution of corporate capital structures and find that little of the variation in leverage is captured by previously identified determinants, such as size, market-to-book, profitability, industry, etc.
Abstract: We examine the evolution of corporate capital structures and find that little of the variation in leverage is captured by previously identified determinants, such as size, market-to-book, profitability, industry, etc. Instead, the majority of variation in leverage ratios is driven by an unobserved time-invariant effect that generates surprisingly stable capital structures: High (low) levered firms tend to remain as such for over two decades. Additionally, this feature of leverage is robust to firm exit, is present prior to the IPO, and is largely unaffected by the process of going public, suggesting that variation in capital structures is primarily explained by factors that remain relatively stable for long periods of time.

592 citations

Journal ArticleDOI
TL;DR: In this article, the authors evaluated the performance of dynamic panel models on corporate finance data, in which the dependent variable may be clustered or censored and independent variables may be missing, correlated with one another, or endogenous.
Abstract: Dynamic panel models play a natural role in several important areas of corporate finance, but the combination of fixed effects and lagged dependent variables introduces serious econometric bias. Several methods of counteracting these biases are available and these methodologies have been tested on small datasets with independent, normally-distributed explanatory variables. However, no one has evaluated the methods’ performance with corporate finance data, in which the dependent variable may be clustered or censored and independent variables may be missing, correlated with one another, or endogenous. We find that the data’s properties substantially affect the estimators’ performances. We provide evidence about the impact of various data set characteristics on the estimators, so that researchers can determine the best approach for their datasets.

574 citations

Journal ArticleDOI
TL;DR: In this article, the authors examine the capital structure implications of market timing in a single major financing event, the initial public offering, by identifying market timers as firms that go public in a hot issue market and find that hot-market IPO firms issue substantially more equity than cold-market firms.
Abstract: This paper examines the capital structure implications of market timing. I isolate timing attempts in a single major financing event, the initial public offering, by identifying market timers as firms that go public in a hot issue market. I find that hot-market IPO firms issue substantially more equity than cold-market firms. The difference represents a genuine timing effect, as it cannot be explained by firm-level characteristics. Market timing depresses the leverage ratio substantially in the very short-run. However, the timing effect on leverage quickly reverses. Immediately after going public, hot-market firms start increasing their leverage ratios by issuing more debt and less equity relative to cold-market firms. This active reversal policy is strongly visible for two years. At the end of the second year following the IPO, the market timing impact on leverage completely vanishes. The results contrast with recent findings that suggest high persistence of market timing effects on capital structure.

484 citations